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Wall Street has certainly had its share of product trends. Some enter the scene with great fanfare, but eventually languish. (Witness the decline of the annuity.) Some, like collateralized debt obligations, seem like a good idea until they nearly bring about the destruction of the financial markets. Yet others, like index funds, revolutionize the way individuals and institutions manage their portfolios. But few products have grown as fast or been as widely embraced as exchange-traded funds.

So now the question is: Can this phenomenal growth continue?

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Exchange-traded funds have $1.2 trillion in assets in 1,476 funds, which account for nearly one-third of U.S. equity trading. That's pretty astounding, given the industry didn't even exist two decades ago. Starting with a single product on the American Stock Exchange in 1993, they picked up steam in the late 1990s, and proceeded to build assets at a rate of more than 30% per year from 2000 to 2010. What started as tradable index funds soon grew more complex, branching into commodities, currencies, derivatives, fixed-income, and more. Then ETFs threw out the indexes altogether by making inroads into active management.

But the growth has been uneven. The ETF industry is exceedingly top-heavy: Three-quarters of ETF assets are managed by the big-three firms of BlackRock, Vanguard Group, and State Street. More than one-third of all assets are held in the 10 biggest funds. And more than half the ETFs on the market today have less than $50 million in assets, putting them in the "maybe" category as to whether they're viable products their sponsors will keep around.

To hear industry participants tell it, exchange-traded funds' explosive growth is only getting started. The rise of index-tracking ETFs will be followed by equally rapid gains via the adoption of actively managed ETFs. This will be accompanied by wider use of ETFs in 401(k) plans and deeper inroads into relatively untapped areas like fixed income. BlackRock's iShares unit predicted this month that U.S. bond ETFs alone could reach $1.4 trillion in the next decade -- bigger than the entire industry today. "We think investors are just beginning to realize the potential of fixed-income ETFs," says Matthew Tucker, head of BlackRock's iShares fixed-income investment strategy.

But the industry optimism may be less than it's cracked up to be, according to Bernstein Research. Those three big growth areas -- active management, 401(k) and other defined-contribution plans, and fixed-income -- will be tougher to penetrate than index investing was. Active management presents challenges for managers who don't want a spotlight on their daily trading. Fixed income isn't as easy to index, and faces the same challenges and more in the active arena, since most bond funds use derivatives, which are not currently approved for use in ETFs. As for the 401(k) industry? Mutual-fund firms have a tight grip on retirement plans, and may not want to cede those fees to cheaper products. A "lack of motivation" among incumbents is how the Bernstein analyst Luke Montgomery charitably describes it.

Topping it all off: ETFs' rapid growth today is somewhat deceptive. High correlation in global markets naturally benefits a predominantly passive industry (more than 95%), but passive investing may cool off when asset prices disperse.

Bernstein's study "Will ETF Growth Hit a Wall?" turned heads last month. Apparently the robust growth it predicted for the industry -- that the $1.2 trillion industry could grow by a healthy 13% per year to reach $6 trillion by 2025 -- was still way below the rosier consensus. McKinsey & Co. predicted last year that ETFs could reach $4.7 trillion globally as soon as 2015, implying U.S. growth of more than twice Bernstein's view. Other estimates shoot as high as $10 trillion by 2020.

Despite the industry chatter it inspired, the study didn't generate much pushback, says Montgomery, who co-authored the report with Brad Hintz and Gabriel Farajollah. After all, the 13% growth is still twice the 6% to 7% growth Bernstein expects from the asset-management business as a whole.

ETFS ARE CLEARLY A GROWTH INDUSTRY, and slowing from 30% a year to 13% is hardly a death knell. But there are some big challenges ahead. Let's break it down.

Active management. Actively managed ETFs, the first and most promising pillar of the industry's future growth, still face a number challenges. That's why there are only about 50 of them on the market, with just $7.5 billion in assets, a fraction of total ETF assets, according to research and data provider XTF.com. ETFs have to disclose their portfolios every day -- an advantage for investors, but a distinct disadvantage for portfolio managers. When a well-known manager signals he's buying (or selling) large amounts of a stock, the market tends to notice, driving prices higher (or lower). Since mutual funds are required to report their holdings monthly (plus a lag in reporting time), there's a degree of confidentiality in their day-to-day trades. In fact, the most successful actively managed ETF isn't an equity fund at all; it's a Pimco bond fund.

A number of companies such as
BlackRock's
blk -0.7996387014505074%BlackRock Inc.U.S.: NYSEUSD373.41
-3.01-0.7996387014505074%
/Date(1425418574052-0600)/
Volume (Delayed 15m)
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326058
P/E Ratio
19.064862104187945Market Cap
62189857798.5889
Dividend Yield
2.3359854268799056% Rev. per Employee
986491More quote details and news »blkinYour ValueYour ChangeShort position
(BLK) iShares and Guggenheim Investments have already explored ways to cloak active-ETF portfolios or build proxies for the disclosures, with little to show for the effort. "Anyone holding their breath on those structures passing through the SEC is going to get very blue in the face," predicts Dave Nadig, research director for industry watcher Index Universe.

There are other issues for active management to tackle. For instance, frequent portfolio turnover is costly, and can eat away at the tax and cost efficiencies that are the main selling points of an ETF.

Bonds. The challenges with active management are also a big factor in the bond market. Traditional indexing isn't always well suited to bonds: Most indexes are weighted toward companies with larger market capitalizations. In the bond world, that means companies and countries that issue more debt -- which are often the companies and countries most in need of financial aid -- make up a larger part of the index.

The other bond problem: They don't trade like stocks. ETFs are best suited to deeply liquid underlying markets, which are lacking in large parts of the bond universe. Many sought-after bonds don't change hands every day. This has pricing implications. It's also forced some index providers to expand the mandate of their products as demand has increased.

401(k)s. This third area of growth may be the toughest to crack of all. Mutual funds have about 55% of the defined-contribution market as of the end of last year, according to the Investment Company Institute. But ETFs have less than 1%, according to Bernstein's figures. (ICI, the fund-industry umbrella group and keeper of statistics, doesn't track ETF holdings in 401(k)s, according to a representative.) A growth opportunity? Potentially. Trouble is, investors don't much need a daily trading vehicle in their long-term holdings, nor do they much value ETFs' tax advantages in a tax-deferred retirement plan. They simply want low fees. This can often be accomplished with an index-tracking mutual fund. Big mutual-fund companies like Fidelity and Vanguard are unlikely to conclude they must shift their existing businesses to ETFs if investors aren't demanding it.

None of which means the ETF business will grind to a halt. To the contrary, it is all but certain to continue growing handily. But maybe not as handily as the industry hopes. "The most significant opportunities for the ETF industry," Montgomery says, "are also the most tenuous."